Final answer:
The cost of debt will increase as the degree of leverage increases because higher leverage is associated with greater risk and interest payments. Lenders charge higher interest rates to compensate for this risk. Economic conditions and competition for financial resources with the government can also affect debt costs.
Step-by-step explanation:
The cost of debt for a business tends to increase as the degree of leverage increases. This is due to the fact that as a company takes on more debt, its interest payments also rise, which can lead to a larger deficit even if other areas of spending remain constant. Lenders perceive highly leveraged companies as riskier and thus demand higher interest rates to compensate for the increased risk.
When economic conditions are favorable, there's an uptick in lending, which can lead to inflated asset prices and quick growth. However, during economic downturns, credit can become scarce and expensive, complicating the situation for businesses that are highly leveraged. Additionally, as debt levels rise, companies may find themselves competing with the government for financial resources, further driving up borrowing costs.